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Tuesday, February 25, 2014

NEPAL: Recent macroeconomic analysis

1. Despite internal and external challenges, Nepal has managed to maintain overall macroeconomic stability through prudent fiscal and monetary policies. The average gross domestic product (GDP) growth rate during the fiscal year (FY) 2007–FY2013 period since the end of its civil conflict has been 4.4%, compared with an average 3.8% during the conflict (FY1996–FY2006). Growth has been largely driven by agriculture and services and has been sluggish in the industrial sector. Growing remittance income and tourism receipts have been crucial in maintaining balance of payments stability despite a widening trade deficit. Even with rising recurrent expenditures, the fiscal deficit has remained below 2.2% of GDP, due mainly to rapid growth in revenue mobilization, but also to low capital expenditure. On the social development front, remarkable progress has been made in reducing absolute poverty, and the country is on track to achieve a majority of the Millennium Development Goal (MDG) targets. A resolution of pressing challenges—an ongoing political transition and structural bottlenecks in particular—combined with reforms to improve the investment climate and the continued growth of internal and external market opportunities would allow Nepal’s growth to accelerate. The economy has the potential to grow at a higher rate than the 5.0% achieved during FY1992– FY1996, the period after its economy was first liberalized but before the onset of its armed civil conflict.

B. Economic performance

2. Economic growth. Despite the global economic slowdown and a difficult and protracted post-conflict political transition, Nepal’s economic growth and overall macroeconomic situation have been stable, if modest. Nepal maintained an average real GDP growth rate (basic prices) of 4.0% during FY2010-FY2013. Service sector growth, aided by a high inflow of remittances and tourism receipts, and good agriculture harvests due to a favorable monsoon have been principally responsible for the growth, despite the weak performance of the industrial sector. In FY2012, the GDP growth rate (basic prices) was 4.5%, the highest achieved during the 2010-2012 period covered by the previous country partnership strategy. The major contributors to service sector growth were hotels and restaurants; transport, storage, and communications; and wholesale and retail trade. All grew at more than a 5.0% annual average between FY2010 and FY2012. The manufacturing growth rate was barely 2.0% a year during the same period. A slowdown in real estate and housing markets impacted construction activities, whose growth declined from a high of 6.2% in FY2010 to 0.1% in FY2012. Following an unfavorable monsoon and a shortage of chemical fertilizers, GDP growth dropped to 3.6% in FY2013.

3. Structural transformation. The economy is not following the traditional mode of structural transformation, i.e., through a decline in dependence on the agriculture sector and an increase in dependence on the industrial sector, including manufacturing. Instead, it is increasingly driven by the service sector, which is resulting in a slow structural transformation. While the contribution of agriculture sector has averaged 35.0% of GDP since FY2004, the contribution of the industrial sector declined to 15.0% of GDP in FY2013 from more than 17% in FY2004. The contribution of the service sector increased from about 46.0% of GDP in FY2004 to 51.0% in FY2013. The structural transformation is largely driven by service sector growth, especially in real estate, housing, construction, tourism, and retail activities that is in turn driven by high foreign remittances. The stagnant industrial sector is a cause for concern.

4. Fiscal performance. Fiscal performance has been sound and the budget deficit low and stable. Some challenges persist, however. These are related in particular to high recurrent expenditures, increasing subsidies, and a potential decline in the growth of revenue mobilization due to slowing growth in remittances, which primarily is used to finance most of the imports. Customs and value-added tax on imported items form the largest portion of the overall revenue mobilization. A limitation on changing the rates and composition of taxation as a result of a partial FY2013 budget—an outcome of the lingering political disagreements—is another issue. The government’s increasing expenditure is being partly met by foreign assistance, which has helped keep the fiscal deficit at around 2.2% of GDP. Post-conflict expenditures related to rehabilitation and reintegration of former insurgent fighters, along with the rising subsidies (mainly for petroleum fuel), have increased recurrent expenditures from 12.7% of GDP in FY2010 to 15.2% of GDP in FY2013. Meanwhile, capital expenditures have declined from 6.4% of GDP in FY2010 to an estimated 3.1% of GDP in FY2013. This has reflected a difficult political transition, repeated delays in bringing out a full budget, and the low absorption capacity of government agencies. About 34% of capital expenditure is financed by foreign aid.

5. Revenue mobilization. Despite the challenging political environment, revenue performance has been strong. Total tax and non-tax revenue mobilization has increased in the post-conflict period, reaching an estimated 17.0% of GDP in FY2013. While tax revenue increased to 15.0% of GDP in FY2013 from just 8.8% of GDP in FY2006, non-tax revenue has on average remained around 2.0% of GDP. Reforms for enhancing the efficiency of tax administration, strengthening the tax monitoring and audit system, and widening the tax net have paid off. In 2012, the government unveiled a 2012–2015 reform plan and a 2012–2017 strategic plan for the Inland Revenue Department. These plans aim to increase tax revenue mobilization to 18.0% of GDP in FY2017.

6. External sector. Remittances of citizens working or living abroad have been crucial in maintaining overall external sector stability. While merchandise exports have been declining and were only 5.1% of GDP in FY2013, due primarily to loss of competitiveness and weak external demand, merchandise imports have been increasing. They equaled 32.2% of GDP in FY2013, resulting in a trade deficit equivalent to about 27.1% of GDP. The high demand for imported goods is largely created by the high remittance inflows, which reached 25.6% of GDP in FY2013, as well as the absence of domestically produced goods. The remittances have also been a key to maintaining a current account and balance of payments surplus despite the wide trade deficit. The stability of the external sector remains vulnerable to fluctuations in these inflows. For instance, the negative impact of a global economic slowdown on the growth of remittance inflows pushed the current account balance into negative territory in FY2010 and FY2011 and also resulted in a negative balance of payments in FY2010. In FY2013, high remittance inflows and a favorable services account led to current account and balance of payments surpluses. Foreign exchange reserves were sufficient to cover 8.9 months of imports of goods and non-factor services.

7. Debt sustainability. Nepal’s external debt declined sharply from 27.6% of GDP in FY2009 to 19.6% of GDP in FY2013. Total national debt decreased in the same period from 41.0% of GDP to 31.7%. Nepal has succeeded in managing and servicing its debt in a timely manner, with no defaults so far. Prudent fiscal policy (an overall fiscal framework and sustained improvement in revenue mobilization), timely repayment of debt obligations, and the concessional nature of the country’s external debt continued to contribute to the stability of its debt position. However, the possibility of a negative shock to remittance inflows and potential for turmoil in the country’s financial sector present risks to the country’s debt sustainability.

8. Inflation. A rise in global food, fuel, and commodity prices have impacted prices in Nepal, as has inflation in India. The inflation rate reached double digits in FY2009 before subsiding to 9.6% in 2010–2012 and 8.3% in FY2012, thanks to a consistent decline in food and beverage prices. However, inflation inched up to 9.9% in FY2013, largely because of a low agriculture harvest, successive increases in petroleum prices, a continuing depreciation of Nepal’s currency against the United States (US) dollar, the impact of supply bottlenecks, and high inflation in India, which is Nepal’s largest trading partner. The Nepalese rupee is pegged to the Indian rupee.

9. Financial sector. Prudent and timely policy interventions and regulatory reforms by Nepal Rastra Bank (NRB), the central bank, have stabilized the financial sector after a severe liquidity crisis in FY2011. Credit flows increased by more than 15% during FY2011-FY2013. In FY2011, lower growth of claims on the private sector and low public expenditure resulted in net savings in the government account. The liquidity crisis in FY2011 was triggered by a slowdown in the growth of remittances and failure to pass a full budget on time. The NRB launched corrective policy measures swiftly to contain the situation. It instructed bank and financial institutions (BFIs) to reduce the share of real estate and housing loans in their overall portfolios to 25.0% by FY2012. It also placed limits on credit-to-deposit ratio BFIs and reintroduced a minimum statutory liquidity ratio for banks. The NRB has also reformed the country capital adequacy framework of 2007 to bring it into line with the new BASEL II standards, and since FY2009 it has started full implementation of class A commercial banks. Based on the Basel II updated standards, it also started implementing the framework for class B (development banks) in FY2011. To increase access to finance and encourage BFIs to widen their operations beyond the urban areas, the NRB is offering special interest rate-based benefits to those that expand their businesses into rural areas. The financial sector is still vulnerable to fluctuations in remittance inflows, a slowdown in real estate and housing markets, and any financial turbulence involving the roughly 24,000 credit and savings cooperatives in the country. These cooperatives are outside the NRB’s regulatory purview and have amassed more deposits than development banks and finance companies combined.

10. Migration and remittances. More than 1,200 Nepalese leave the country every day due to the lack of job opportunities at home and the lure of high wages abroad. This outmigration to find work in destinations such as Malaysia and the Gulf States has resulted in a shortage of workers in the agriculture and industrial sectors. Growing internal migration from rural to urban areas has further impacted the agriculture sector. Against the backdrop of the weak industrial sector, lack of adequate investment, and an economy where demand for goods and services is largely met by imports, remittance inflows have been crucial in supporting not only macroeconomic stability but also household consumption and expenditures. A massive rise in these remittances, which more than 56% of households receive, has fuelled consumption of imported goods, contributed to a multifold rise in real estate and housing prices, and facilitated the rise of the number of banks and financial institutions. It has also supported high revenue mobilization, increased foreign exchange reserves, helped maintain balance of payments stability despite a widening trade deficit, and reduced absolute poverty. Remittances are impacting almost all levels of the economy. They also contributed to problems related to the so- called Dutch Disease, which foreign funds inflows drive up the value of a country’s currency, making its export prices uncompetitive, and results in a decline in activity in the tradable sector (mainly manufacturing) compared with that in the non-tradable sector (mostly services).

11. Emerging challenges. The country’s key economic challenge is to generate the high, inclusive, sustainable growth that is necessary to create employment opportunities for Nepal’s people, as well as more rapid and sustainable poverty reduction. To do this, the country must address its acute power shortage and overall infrastructure deficit. Both steps are critical to promoting private sector investments and effective public service delivery. The severe infrastructure deficit has combined with difficult labor–industry relations to form a key obstacle to the growth of the industrial sector, which is necessary for an economic structural transformation and the creation of more jobs. Inadequate access to finance is also a critical constraint to private sector investment and growth. Another challenge lies in the financial sector, which is vulnerable due to weak monitoring and supervision. This has left many BFIs, especially the smaller ones, poorly managed and suffering from high ratios of nonperforming assets. Economic planning has also been inadequate. The country’s substantial remittance income has served to help maintain macroeconomic stability but it has not been channeled into productive investments for achieving higher, long-term, sustainable growth.

12. Competitiveness. Although it enjoys the benefits under the General System of Preferences of entry to the developed country markets and free trade with India, Nepal’s exports are declining. This is mainly due to its abundant domestic supply-side constraints, all of which limit the competitiveness of Nepalese products and inhibit private sector development. The country’s electricity shortage is crippling the industrial sector, and most firms operate below capacity. Manufacturing plants are compelled to use petroleum fuel generators when there is no electricity supply. This increases their cost of production and makes the final price of their goods uncompetitive. Nepal’s inadequate and insufficient electricity and transport infrastructure has been identified as a principal binding constraint on economic growth. The poor state of labor relations is also a burden. The occasional strikes along the main highways and country-wide strikes have been disrupting production, supply, and distribution, especially after FY2006. Labor uncertainty has increased the lead time between the placement of an order and the receipt of goods from Nepal’s manufacturers, resulting in a drop in demand for the country’s exports. The combative labor–industry relationship has resulted in the closure of several factories, including those of multinational companies. Nepal’s labor costs are rising faster than productivity levels. The minimum wage, which has been raised many times since 2006, is the highest in South Asia. The lack of qualified workers has also affected production and wages.

13. Constraints to doing business: Successive perception surveys of the business community incorporated in the World Economic Forum’s annual Global Competitiveness Report during 2010-2013 showed that government instability, corruption, inefficient government bureaucracy, policy instability, and restrictive labor regulations were the five greatest obstacles to doing business in Nepal. The other negative factors identified in the surveys were poor access to finance, a poor labor force work ethic, high inflation, crime and theft, an inadequately educated work force, tax regulation, tax rates, insufficient capacity to innovate, foreign currency regulation, and poor public health. A business survey conducted in 2012 by the Federation of Nepalese Chambers of Commerce and Industry identified political instability as the most critical challenge facing the economy, followed by the insufficient energy supply, poor governance, labor problems, strikes, and financial sector instability.

C. Economic outlook

14. Higher growth potential. In FY2013, the growth rate (at basic prices) was an estimated 3.6%, down from 4.5% in FY2012. Growth slowed main because of a delay in the monsoon and a shortage of chemical fertilizers during the peak paddy planting season, both of which affected agriculture production. GDP growth was also adversely affected by delays in passing a full budget and a deceleration of remittances inflows, which impacted service sector growth, financial sector stability, and the balance of payments. Nevertheless, the growth rate since 2008 has been 4.4%, demonstrating the economy’s resilience in the face of political instability. Nepal has natural resource endowments; access to the large, fast-growing, nearby markets of the People’s Republic of China and India; and comparative advantages in key sectors such as hydropower, tourism, and agriculture. The country has the potential to achieve growth rates of 6%–7%. For this to happen, however, it must tackle its binding constraints, the foremost being its infrastructure bottlenecks. The acute electricity shortage, which exists despite the country’s enormous hydropower potential, is severely constraining all economic activities and private investments above all. The inadequate transport networks, urban infrastructure, and irrigation systems also limit the expansion of economic opportunities. At present, the country’s economic base is narrow and heavily dependent on remittance incomes. Agriculture and services activities are characterized by low productivity. Manufacturing sector activities remain stagnant due to infrastructure bottlenecks, difficult industrial relations, and an unfavorable business environment.

15. Inclusive growth. While Nepal made impressive progress in the past decade toward achieving inclusive growth, much more needs to be done to sustain and accelerate this success. High, sustainable growth is fundamental to generating greater and better employment opportunities. To be inclusive, the country’s growth needs to be employment-centric. Under the current economic situation, however, the vast majority of the 450,000 entrants to the labor market every year resort to either low-skilled jobs overseas or low-value-added service sector activities domestically. A weak education system and a low skills base are key constraints to promoting economic diversification and higher competitiveness. The technical and vocational education sector needs to be expanded and restructured to respond to the needs of the labor market more effectively. The quality of education also requires major upgrading to provide greater access to secondary and tertiary education and make that education more relevant to the students’ and the economy’s needs. To diversify its economy and accelerate inclusive economic growth, Nepal also needs to improve other basic services, such as health, water and sanitation, and electricity, as well as provide better manufacturing production and delivery, enhance the capacity of small and medium-sized enterprises, open appropriate microfinance avenues for promising enterprises, and make other reforms that support inclusion. It must strengthen its social protection programs to prevent extreme depravation and shield the poor and vulnerable groups from negative exogenous shocks to their incomes and livelihoods. It also requires more work on labor market policies and programs, social insurance programs, social assistance and welfare schemes, child protection programs, and disaster risk management that focuses on vulnerable populations.

16. Accelerating inclusive growth will require a substantial increase in capital investments. The government’s capital expenditure stood at barely 3.1% of GDP in FY2013, sharply down from 6.6% of GDP in FY2013. Public capital investment should be raised to at least 8% of GDP by (i) rationalizing recurrent expenditures, including though reforms of loss-making public enterprises such as the NEA and the Nepal Oil Corporation (NOC); and (ii) enhancing the capacity of public agencies to deliver and sustain quality infrastructure in a timely and effective manner. Strategic planning of infrastructure is critical to maximize growth and the employment impacts of industrial growth. Private investments in infrastructure need to be promoted, particularly in the energy sector to address the crippling domestic power shortage and tap huge potentials for exports. This calls for creating an enabling environment for PPP. PPPs will provide a basis for developing private industries. Labor-intensive manufacturing, agroprocessing, and modern services must grow. Private investments, including foreign direct investment (FDI), need to be attracted by improving the investment climate, incentives, labor relations and laws, and social security systems. Growth frontiers should be identified and nourished to promote exports and substitute imports in areas where Nepal can be competitive. Pursuing integration with rapidly growing neighboring economies can further accelerate the process.

17. Investment. The total domestic capital investment commitment by registered industries reached NRs84.4 billion in FY2012, or 5.5% of GDP. The largest share of investment is usually in the energy sector (3.6% of GDP in FY2012), followed by manufacturing (1.1% of GDP), services (0.3% of GDP), and tourism (0.1% of GDP). While still very small, the upward trend in FDI inflows is likely to continue, given the high investments, both existing and planned, in the hydropower, transport, and services sectors. Total FDI inflows, as recorded in the balance of payments, increased from $5.45 million in FY2008 to $103.60 million (0.5% of GDP) in FY2012. There is much scope for FDI to increase—the existing inflow is a mere 0.3% of total FDI in South Asia. While domestic and foreign investments are increasing in the infrastructure (particularly hydropower), tourism, and retail sectors, the same is not true for agriculture and manufacturing, and in other services subsectors. A gradual relaxation of the supply-side constraints (such as the electricity shortages, market distortions produced by middlemen and syndicates, poor industrial relations, a lack of qualified workers, the skills gap, and inadequate supply of agricultural and industrial inputs) would attract more investment, which is vital to generate enough employment opportunities to absorb the nearly half a million new entrants to the labor force each year. While the capital market needs to be developed for long-term private sector investment in infrastructure, the PPP modality seems a good option for investment needs in the interim.

18. Inflation and monetary conditions. Inflation will be largely determined by the prices in neighboring India, international fuel prices, food prices, and rigidity in the supply bottlenecks. Given the impact of unfavorable rainfall, droughts in major crop-producing countries, and potential trade restrictions that might be imposed by major grain exporters, global food prices are projected to remain high in the coming years. This could be reflected in domestic prices to some extent, leading to high inflation. In FY2013, inflation was 9.9%, up from 8.3% in FY2012. Meanwhile, in the financial sector, a market correction is ongoing in real estate and housing prices, and the BFIs are adjusting their loan portfolios to comply with the NRB’s directives. Aiming to consolidate the BFIs and reduce their numbers, the NRB and the Ministry of Finance MOF are encouraging mergers. The government is also planning to introduce stricter regulations and supervision of proliferating credit and savings cooperatives, whose risky deposit and lending behavior might negatively impact the financial sector at large and, through it, the real sector. Assuming a steady increase in the growth of remittances and tourism receipts, the balance of payments will remain positive.

19. Exchange rate volatility. As a result of the peg with the Indian rupee, the Nepalese rupee has also depreciated rapidly against the US dollar. Concerns over a prospective winding down of quantitative easing by the US Federal Reserve triggered the depreciation of the Indian rupee. The decline was complicated by India’s slow economic growth and a widening current account deficit. The depreciation of Indian rupee is automatically reflected in the exchange rate of the Nepalese rupee against the US dollar (declines of 19.9% in FY2012 and further 6.7% in FY2013). If Nepal’s currency continues to weaken at this rate, (i) the government’s debt service payments will rise; (ii) the NOC will incur heavy losses as it procures petroleum products and liquefied gas at higher prices and sells them at subsidized prices in the domestic market; (iii) the NEA’s payments to the independent power producers with which it has power purchase agreements in foreign currency will go up, further exacerbating its balance sheet issues; and (iv) Nepal’s import bill will increase. These factors may influence macroeconomic stability, debt sustainability, and balance of payments stability. The government’s liabilities, including the losses of the NOC and the NEA, would increase and the credibility of the NEA as an energy offtaker could further erode. The higher cost in Nepalese rupees to service external debts might impact debt sustainability. However, given the incentives that such a continued current depreciation could provide for workers abroad to remit more money, the balance of payments might not see much deterioration despite the likely rise in the trade deficit. While the exchange rate volatility has severe negative implications for certain public entities and macroeconomic variables (state-owned enterprises, inflation, and balance of trade), it may have mild and mixed impact on other variables such as GDP growth, debt sustainability, and external sector stability.

20. Overall, Nepal is expected to maintain macroeconomic stability, thanks to continued revenue administration reforms and growth in revenue mobilization, high remittance inflows, and prudent fiscal and monetary policies. If it can made progress in its political transition, resolve its supply-side constraints, and carry out further reforms to boost private sector investment, Nepal has the potential to achieve a high growth rate in the years ahead.

About

Formerly, economics officer at Asian Development Bank, Nepal Resident Mission. Worked as a researcher at SAWTEE, Kathmandu. Also, worked as a consultant for Ministry of Commerce & Supplies, Government of Nepal; FAO; UNDP, GIZ-CIM, and ADB among others. I was an op-ed columnist for Republica between December 2008 – June 2012. I also worked as a Junior Fellow for Trade, Equity & Development program at Carnegie Endowment for International Peace, Washington, D.C .